Last week's announcement of more U.S. tariffs on Chinese goods may have undermined the prospects for small-cap stocks to rebound this year, even after a brief respite from the Federal Reserve's recent interest-rate cut.

Just a day after the Fed cut interest rates for the first time in more than a decade, President Donald Trump vowed on Aug. 1 to impose 10% tariffs on an additional $300 billion of Chinese goods beginning on Sept. 1.

The prospect of lower interest rates has helped combat concerns about slowing economic growth, which have hampered the performance of small-cap shares over the past year. But such relief has quickly faded as fears have mounted that additional tariffs could impede the U.S. economy.

A U.S. economic slowdown would bode especially poorly for small-cap companies, which tend to be more domestically focused than their large-cap counterparts.

"What small caps need above all else is a confirmation that the U.S. economy is on solid footing," Quincy Krosby, chief market strategist at Prudential Financial in Newark, New Jersey, said in an interview on Tuesday.

Strategists have said the risks to the U.S. economy increase as the trade war escalates. Morgan Stanley's chief economist wrote in a note on Monday that if the trade war intensifies with the United States raising tariffs to 25% on all imports from China for four to six months, the global economy could enter a recession in three quarters.

Moreover, he wrote, "about two-thirds of goods tariffed in this round are consumer goods, which could lead to a more pronounced impact on the U.S. as compared to earlier tranches."

Since Trump's announcement last Thursday of additional tariffs, the small-cap Russell 2000 Index has fallen about 3.1%, further than the benchmark S&P 500's 2.1% slide.

SHRINKING PROFIT MARGINS

Given the renewed threat of tariffs, small-cap stocks are likely to continue to underperform for at least the next few months, said Keith Lerner, chief market strategist at SunTrust Advisory Services. SunTrust recently upgraded its rating on U.S. small-cap stocks, citing their low valuations. But Lerner said he expects investors to remain wary of small-cap stocks until the possibility of further escalation in the U.S.-China trade war recedes.

"Small caps looked like they were about to break out," he said. "But as soon as (Trump's) tweet came out, they broke down."

In particular, recent developments on tariffs have brought small-cap companies' shrinking profit margins back into focus, an issue that has dragged down their shares over the past year.

Revenue growth for smaller companies has largely kept pace with that of large-cap companies, said Steven DeSanctis, equity strategist at Jefferies in New York. But rising wage and input costs have resulted in lower profits for the group. According to IBES data from Refinitiv, as of Wednesday, earnings for companies in the small-cap S&P 600 Index were expected to have declined 6.3% year-over-year for the second quarter of 2019 while second-quarter earnings for S&P 500 companies were expected to have risen 2.7%.

Furthermore, profit margin projections have fallen for small-cap companies more sharply than for large-cap companies since the end of June, according to research from Lori Calvasina, head of U.S. equity strategy at RBC Capital Markets. Added costs from tariffs would further depress small-cap earnings.

"There's definitely a margin issue if costs rise and they can't pass them on to consumers," DeSanctis said.

Heightened trade tensions in recent days have raised expectations that the Federal Reserve will further cut interest rates. As of Thursday, traders were fully pricing in a 25 basis-point cut at the Fed's next meeting in September, according to CME Group's FedWatch tool.

But even lower rates would do little to bolster small-cap shares without at least a detente in U.S.-China trade relations, said Kristina Hooper, chief global market strategist at Invesco in New York. Conversely, a walk-back of the additional tariffs coupled with a reacceleration of U.S. economic data following the Fed's recent rate cut could help jump-start small-cap shares, in her view.

"That's the scenario where small caps could really perform better," she said.

Last week's announcement of more U.S. tariffs on Chinese goods may have undermined the prospects for small-cap stocks to rebound this year, even after a brief respite from the Federal Reserve's recent interest-rate cut.